MONETARY POLICY FRAMEWORK AND TRANSMISSION MECHANISM

Yiping Huang

2018.8.15

”As China has the features of both large transition economy and an emerging market economy, the central bank of China and its monetary policy are yet to be well understood by the outside world”

By former PBC governor, Zhou Xiaochuan,

2016 Michel Camdessus Central Banking Lecture, IMF

Similarities and differences

• The monetary policy framework assembles those of the advanced market economies in

many ways

• A specialized central bank; an MPC;

• A set of policy objectives;

• Intermediate targets and some policy tools

• But it also differs at almost every fronts

• The PBoC is not independent

• Multi-objective

• Mostly quantitative instruments

• The McCallum rule

Outline

• Monetary policy framework in transition

• How does the monetary policy work?

• The transmission mechanisms of monetary policy

• Identification of the monetary policy rule

• Future outlook of China’s monetary policy

Transition of the monetary policy frameworkSection 2

The transition economy

• Brief history of China’s central banking

• In 1905, the Household Bank was established in the Qing Dynasty; In 1908, the Daqing Bank, was set up and was later restructured into the Bank of China in 1911; In 1924, the Nationalist Government created the Central Bank; In 1948, the Communists established the People’s Bank of China (PBoC)

• Economic transition

• “Dual-track”: continuous support to the state-owned enterprises (SOEs), while allowing the non-state sectors to expand quickly (Growing out of the plan: Naughton 1995)

• “soft budget constraint” and “government guarantee”

• Unique pattern of China’s financial reform and development - strong on quantity but weak on quality

• Such non-market behavior explains why lack of central bank independence and use of quantity-based policy tools are actually favorable

Transition of the monetary policy framework

• The period of central credit plan (1949-1978)

• The PBoC and financial intermediation played only limited roles

• The period of direct credit control (1979-1997)

• The PBC formulated a direct regulatory framework for credit management

• bank credit as the main intermediate policy target

• The period of indirect control of money and credit (1998-)

• Indirect management framework for aggregate money and credit

• Interest rate instruments became more important (banks’ deposit and lending rates;

and the interbank markets, SHIBOR)

• Two key themes of the transition: from direct to indirect controls and from

quantity to interest rate regulation

How does the monetary policy work in China?Section 3

The decision-making process

• The PBoC is not an independent central bank; it is under the leadership of the State

Council

• The probable process of monetary policy making

• First, the State Council decides on key economic policy targets

• Second, the PBoC prepares proposal for monetary policy actions

• Third, the State Council makes the final decision

• Unusual way describing monetary policy stances

• The Chinese monetary policy stances are often described as “tightening”, “prudent”

and “easing”.

• Sometimes, “prudent” stance may be further clarified as “prudent with a tightening

bias”, “prudent neutral”, or “prudent with an easing bias”.

The monetary policy framework

Operational instruments Operational targets Intermediate targets

• Money supply

(narrow money

supply M1 and

broad money

supply M2)

• Bank credit (and

also the total

social financing)

• Market interest

rate (such as

SHIBOR)

• Non-borrowed

reserves

• Borrowed reserves

• Short-term money

market rate

• Monetary base

• Quantity-based

instruments. (e.g.

RRR, CBBs,

central bank

lending, OMOs,

etc.)

• Price-based

instruments (e.g.

banks’ base

deposit and

lending rates)

• Window-guidance

Policy objectives

• Rapid economic

growth

• Full employment

• Low and stable

inflation

• Balanced

external account

GDP growth and inflation rate

-30

-20

-10

0

10

20

30

19

60

19

62

19

64

19

66

19

68

19

70

19

72

19

74

19

76

19

78

19

80

19

82

19

84

19

86

19

88

19

90

19

92

19

94

19

96

19

98

20

00

20

02

20

04

20

06

20

08

20

10

20

12

20

14

20

16

GDP growth Inflation

7-day SHIBOR and CNY/USD exchange rate

6

7

8

0

2

4

6

8

10

10

/20

06

04

/20

07

10

/20

07

04

/20

08

10

/20

08

04

/20

09

10

/20

09

04

/20

10

10

/20

10

04

/20

11

10

/20

11

04

/20

12

10

/20

12

04

/20

13

10

/20

13

04

/20

14

10

/20

14

04

/20

15

10

/20

15

04

/20

16

10

/20

16

04

/20

17

10

/20

17

04

/20

18

Shibor Exchange rate

Official reserve interest rate and re-lending rate

0.00

2.00

4.00

6.00

8.00

10.00

12.00

01

/19

87

03

/19

88

05

/19

89

07

/19

90

09

/19

91

11

/19

92

01

/19

94

03

/19

95

05

/19

96

07

/19

97

09

/19

98

11

/19

99

01

/20

01

03

/20

02

05

/20

03

07

/20

04

09

/20

05

11

/20

06

01

/20

08

03

/20

09

05

/20

10

07

/20

11

09

/20

12

11

/20

13

01

/20

15

03

/20

16

05

/20

17

07

/20

18

Official reserve interest rate Re-lending rate

Liberalization of banks’ base deposit and lending rates

Year Key reform steps

1983 Granted right to PBOC to adjust benchmark lending rate

1998-2004 Gradually increased the upper limit on lending rates

1999 Liberalized interest rate in deposit wholesale market

2000 Liberalized foreign currency lending rates

2000 Liberalized foreign currency deposit rates for deposits over $3 million

2003 Removed floor on foreign currency deposit rates

2004 Removed ceiling on lending rates

2004 Removed floor on deposit rates

2012 Increased the lower limit on lending rates

2012-2015 Gradually increased the upper limit on deposit rates

2013 Removed floor on lending rates

2015 Adopted the deposit insurance scheme; Removed ceiling on deposit rates

The transmission mechanismsSection 4

Transmission mechanisms

• Possible transmission paths:

• Policy instruments operational targets intermediate targets ultimate goals

• Central bank financial institutions/financial markets enterprises/households

national income/national price

• Possible transmission channels:

• Interest rate channel

• Credit channel

• balance sheet channel (broad credit channel)

• bank lending channel (narrow credit channel)

• Wealth channel

• Exchange rate channel

• Expectations channel

Transmission mechanisms

• Empirical assessment of the Chinese case

• Mixed findings on almost all fronts, but general patterns exist:

• interest rate channel was quite weak in the earlier years but grow much stronger

in recent years

• credit channel is quite effective, relatively speaking

• functioning of the wealth channel is unclear, as monetary policy has clear effects

on asset prices but asset prices do not have stable impacts on consumption

• exchange rate channel is also not stable

Transmission mechanisms

• Interest rate channel

• PBC doesn’t directly adjust or target at the short-term market rates

• modest role of interest rates in the Chinese economy and a weak linkage between

interest rate and real sector activities (Laurens and Maino 2007, Koivu 2009)

• banks’ credit allocation favors the large SOEs, which still exhibit certain degrees of

“soft budget constraint”

• Interest rate liberalization and other market-based reforms

• changes in interest rates have considerable impacts on economic activities and

inflation in China when using more recent economic data (Fernald et al. 2014, Zha

and Chen 2017)

Transmission mechanisms

• Credit channel

• Tests for existence of the bank lending channel

• focusing on the correlations among aggregate output, bank credit, and indicators of

monetary policy, reveal mixed findings (Zhou and Jiang 2002)

• examining the impulse responses from multi forms of VAR models (Sheng and Wu

2008, Sun et al. 2010, Nguyen and Boateng 2013, Li and Lee 2015)

Transmission mechanisms

• Wealth channel

• Given China’s persistent high saving rate Chinese households’ saving the

consumption behaviors are not sensitive to changes in interest rates reduce

effectiveness of the wealth channel (Koivu 2012, Zhang and Huang 2017)

• Exchange rate channel

• Transmission from monetary policy to exchange rate remains a problem (Zhang and

Huang 2011)

• Transmission from exchange rate to the real economy functions relatively effectively

(Fang 2010, Fang and He 2010)

Identification of the monetary policy ruleSection 5

Identification of the monetary policy rule

• Review of the policy rules

• Taylor rule (Taylor 1993)

• describes how central banks should raise the target interest rate when the expected inflation is higher than the desired target and when the actual output level is higher than the natural output

• McCallum rule (McCallum 1988)

• describes growth of money supply as a function of growth of real GDP and money velocity

• revised McCallum rule describes how central banks should reduce the money supply when the expected inflation is higher than the desired target and when the actual output level is higher than the natural output

• The McCallum rule is much less prominent than the Taylor rule today

• VAR models (Sims 1992)

Identification of the monetary policy rule

• The Chinese case

• There are still quite a lot of controversies and confusions about whether the interest rate or the

money supply (or bank credit/TSF) is more appropriate as an intermediate target for the

Chinese monetary policy today

• If the Taylor rule tracks China's monetary policy well, then taking the interest rate as an

intermediate target will offer more policy targets: Xie and Luo (2003)

• Given the prominent role of money supply in China’s monetary policy, a McCallum

monetary policy rule based on control of money supply could be more appropriate:

Burdekin and Siklos (2008), Liu and Zhang (2007), Sun, Gan and Hu (2012)

• Whether China’s recent monetary policy is better characterized by the Taylor rule or the

McCallum rule: Kong (2008), Liu (2015), Sun (2015), Wu and Lian (2016)

• Forward-looking rules for China’s monetary policy from a regime-switching perspective:

Zheng et.al. (2012), Zha and Chen (2017)

Future outlook of China’s monetary policySection 6

Future outlook of China’s monetary policy

• Should the PBC become an independent central bank?

• Focus on key objective; Policy coordination might be desirable

• Should the monetary policy reduce the number of its objectives?

• Less objectives should be better (Tingergen’s rule); Others might be critical, such as

financial stability

• Should a short-term market interest rate become the key operational target?

• Absolutely; But perhaps the quantitative rule is still useful for parts of the economy

• PBoC may further converge with the Fed or the ECB, but it may never look

exactly like them